The current system of taxing multinational firms relies on separate accounting: firms account for earnings and costs in each location in which they operate. This system generates a large tax incentive to earn income in low-tax countries, and multinational firms respond by earning disproportionate profits in low-tax locations.

We propose a system of formulary apportionment for taxing the corporate income of multinational firms. Under our proposal, the U.S. tax base for multinational corporations would be calculated based on a fraction of their worldwide income. This fraction would simply be the share of their worldwide sales that are destined for customers in the United States.

This system is similar to the current method that U.S. states use to allocate national income. The state system arose due to the widespread belief that it was impractical to account separately for what income is earned in each state when states are highly integrated economically. Similarly, in an increasingly global world economy, it is difficult to assign profits to individual countries, and attempts to do so are fraught with opportunities for tax avoidance.

Under our proposed formulary apportionment system, firms would no longer have an artificial tax incentive to shift income to low-tax locations. This would help protect the U.S. tax base while reducing the distortionary features of the current tax system. In addition, the complexity and administrative burden of the system would be reduced. The proposed system would be both better suited to an integrated world economy and more compatible with the tax policy goals of efficiency, equity, and simplicity.